Say it ain’t so, Warren

With allegations of insider trading at Buffett’s Berkshire Hathaway, is the bloom finally coming off America’s favourite investor?

When 40,000 Berkshire Hathaway shareholders descend on Omaha, Neb., for the company’s annual meeting later this month, they can expect an awkward moment early on. Each year, Berkshire’s grandfatherly CEO Warren Buffett kicks off the event with a video montage of comedy skits and advertisements for his many subsidiaries, such as Dairy Queen and Geico insurance. And every year the movie features a classic newsreel from two decades ago, when Buffett went before Congress with a principled message for his employees: “Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” Until a few weeks ago that was just one of many folksy aphorisms Buffett is famous for. But if the clip rolls on April 30, and the Buffett of 1991 utters those words, all eyes will be on the Buffett of 2011, who just sat by while one of his most high-profile employees put Berkshire’s reputation through an industrial shredder.

An uproar over questionable stock purchases by former senior executive David Sokol has put the world’s most famous investor on the hot seat like never before. Buffett has endured intense criticism from lawyers and financial columnists, while Wall Street types everywhere have suddenly discovered their moral outrage and gone on the attack. He’s been called a con man, a hypocrite and, perhaps most biting of all, “very unBuffett-like.” In short, the incident has sparked a wholesale reassessment of the Creamsicle-loving, ukulele-strumming billionaire. The cult of Buffett is in turmoil.

The question now is whether the crisis will leave any lasting damage. It’s hard to imagine those investors in Omaha, who Buffett has made exceedingly wealthy, ever giving up the faith. And there’s more than a little envy and resentfulness behind many of the attacks on his character.

But the fact is, Buffett is not just another billionaire with a keen eye for cheap companies. For people on Main Street America who understand the importance of the stock market but deplore the greed and dirty tricks associated with it, Buffett was the guy in the modest corner office they wished all CEOs could be. And now they’re left to wonder whether he’s really all that different. “People have elevated Warren Buffett into the god of value investing,” says Vitaliy Katsenelson, chief investment officer in Colorado’s Investment Management Associates. “Now we’ve found out that the god is not perfect.”

Things began to unravel for Buffett in late March when he released what he generously described as an “unusual” statement. The letter told shareholders that Sokol, one of his most important lieutenants and a man widely seen as Buffett’s potential replacement, had suddenly resigned. Buffett praised Sokol, calling his contributions “extraordinary.” Then the 80-year-old Berkshire chief detailed a series of stock transactions by Sokol that left Buffett-watchers stunned. In January, Sokol purchased nearly $10 million worth of shares in a chemical company, Lubrizol, just one week before he suggested to Buffett that Berkshire buy the company. When Buffett announced the US$9.7-billion takeover on March 14, Lubrizol’s shares jumped 30 per cent, netting Sokol an instant US$3-million profit.

Buffett insisted Sokol’s actions had not been “unlawful.” Sokol had made a “passing remark” about his personal stake in Lubrizol when he pitched the company as a takeover candidate, Buffett wrote. And in a remarkable feat of hairsplitting, Buffett absolved Sokol of any wrongdoing since the executive never had a say in whether or not Berkshire would actually buy Lubrizol. Then he added that Sokol’s resignation was not related to his trading in Lubrizol. And with that, Buffett deemed the issue resolved. “I have held back nothing in this statement,” he wrote. “Therefore, if questioned about this matter in the future, I will simply refer the questioner back to this release.”

Buffett is hailed as the Oracle of Omaha for his prescience in matters of investing, but he failed to foresee the ferocity his disclosure would unleash. It wasn’t just the dubious timing of Sokol’s trading. The breezy way Buffett tried to brush it all away angered many. Far from being “ruthless” toward Sokol, Buffett was almost fawning in his letter. “I’m shocked that Buffett is so sanguine about this,” said Jeffrey Matthews, a Berkshire investor, hedge fund manager and author of the book Pilgrimage to Warren Buffett’s Omaha, in an interview with Bloom­berg news. “As a shareholder and as a guy in the business, if one of my analysts did this to me, I’d fire him in a nanosecond.”

There are serious questions as to whether Sokol acted illegally, despite Buffett’s assertion to the contrary. Some believe his trades in Lubrizol amounted to insider trading. Sokol has insisted he bought the company for his personal portfolio simply because it looked cheap, and that he didn’t have any information that wasn’t publicly available. Yet Sokol used his influence as a representative of Berkshire to arrange a personal meeting with Lubrizol’s CEO James Hambrick. Berkshire’s own insider trading policies suggest Sokol was in the wrong. In a memo from Buffett posted on Berkshire’s website, employees are told not to buy shares in companies in which Berkshire “may in the future invest.”

Allegations of insider trading, and Buffett’s apparent willingness to look the other way, come at a time when courtrooms are packed with disgraced Wall Street lawyers and executives who played fast and loose with insider knowledge. Whether true or not, the accusations have dragged Berkshire into the morass. When the Argyle Executive Forum, a New York business networking group, surveyed its 800 members, more than three-quarters said that whether Sokol’s trades were illegal or not, they were unethical.

That view flies in the face of a reputation Buffett has spent decades building. Despite overseeing a company with US$136 billion in revenue, he collects an annual salary of just $100,000. He lives in a modest home in Omaha, and says America’s wealthy don’t pay enough taxes. Several years ago he announced he would donate his entire fortune, currently estimated at US$50 billion, to a charity run by Bill Gates. Buffett has also taken every opportunity to needle Wall Street. He’s blasted the abuse of stock options to inflate executive pay. He preaches a buy-and-hold investment strategy at a time when hedge funds chase short-term gains. And in times of crisis he emerged as a voice of calm; with markets in free fall in early 2009, Buffett assured investors the economy would improve, and it did. In short, he’s built a career out of making conventional business people look bad by comparison.

But the varnish was already starting to come off Buffett’s squeaky-clean image before the Sokol fiasco. In 2007, Berkshire invested in PetroChina, the Chinese state-run oil company that activists argue was complicit in genocide in Sudan, only to dump its stake a year later amid public outrage. During the financial crisis, Berkshire landed a sweetheart deal to buy US$5 billion worth of shares in Goldman Sachs. The move was characterized as a vote of confidence in American finance, but the fact is several Berkshire investments, including Goldman, General Electric and Wells Fargo, reaped huge gains thanks to bailouts from Uncle Sam. Another Berkshire company, the credit-rating agency Moody’s, has also been accused of contributing to the crisis by awarding triple-A ratings to worthless mortgage-backed securities, a charge Buffett has refused to discuss. Then, last year, Buffett was accused of being a hypocrite after Berkshire issued billions of dollars in new shares in order to buy the Burlington Northern Santa Fe railway for $34 billion, despite the fact he repeatedly blasts companies for using their shares for acquisitions.

For some of Buffett’s long-time critics, the Sokol affair has simply exposed the real Buffett. In a scathing interview on CNBC just days after Buffett’s letter was released, Michael Steinhardt, the chairman of Wisdom Tree Investments and a Wall Street veteran, accused the media of giving Buffett a free pass, and called the Berkshire chief the greatest PR person of the modern era. “He has managed to achieve a snow job that has conned virtually everyone in the press to my knowledge, and it is remarkable that he continues to do it,” he said. Steinhardt even criticized Buffett over his promise to give away his fortune, accusing him of doing nothing to support charities for the first 70 years of his life, then scoring a media-relations coup with his vow to give it all away. “The biggest thing we have to worry about is how long it will take for Buffett to come down to Earth, where he should have been a long time ago.”

It’s clear from a cursory look at Berkshire’s performance over the last half-century that Buffett has done something right. The compounded annual return of Berkshire between 1965 and last year was 20.2 per cent, versus 9.4 per cent for the S&P 500. Put another way, a $1,000 investment in 1965 would be worth more than $8 million today. Yet it’s also true that Berkshire’s performance has been spotty of late. In four of the last 10 years, the S&P 500 actually outperformed Buffett, though on the whole Berkshire’s returns over the last decade still came out on top.

For his part, Bob Miles, a Berkshire shareholder since 1995 and author of several books on Buffett, says the vilification of Sokol is unwarranted. He sees nothing wrong with the former executive buying a personal stake in a company and then bringing it to Buffett. And he says the incident has overshadowed Sokol’s many contributions to the company. “What’s amazing to me is all this press time devoted to something that I as a shareholder think is fine,” he says. “If the Lubrizol deal closes, it will help shareholders earn US$1 billion a year. That’s an awful lot of value added by a senior manager who has not done anything unlawful or unethical.”

That’s not to say Berkshire doesn’t have its problems, says Miles. He points to two in particular—Berkshire’s sheer size and Buffett’s old age. The bigger Berkshire gets, the harder it is for the company to find investments that are large enough to boost its performance. Meanwhile, with Sokol now out of the picture, the field of internal candidates seen as potential successors to Buffett just shrank from four to three. It’s a concern shared by rating agency Standard & Poor’s, which said the Sokol affair raises questions about Berkshire’s “corporate infrastructure.” With just 20 employees working in the Berkshire head office, it lacks the layers of corporate governance one would normally associate with a company of its size.

There is one reason to expect Buffett to pull through this episode relatively unscathed. He’s done it before. In the late 1980s Berkshire became the largest shareholder at Salomon Brothers, one of the Wall Street investment firms Buffett so often tsk-tsked, and he took a seat on the board. Then, three years later, a rogue trader rocked the firm, and Buffett found himself caught up in the scandal. In 1992, Michael Lewis, a former Salomon bond salesmen who quit and became one of the sharpest chroniclers of Wall Street excess with his books Liar’s Poker and The Big Short, turned his sights on Buffett in an article for The New Republic. Lewis argued the Salomon ordeal tainted Buffett’s reputation. “The corrosion of Buffett by the demands of the market has been largely masked by his moralistic charm,” Lewis wrote. “Nowhere has there been any serious discussion of the shift in what Buffett actually does for his money.” Yet since then Buffett’s charm has only shone brighter, and his popularity—and wealth—has continued to expand.

The difference now is that Buffett, at 80, is far closer to the end of his life than he was then. Given that, you’d think preserving his reputation would be more important to him now than ever before.

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